Harnessing the benefits of Financial Innovation – Part 1

Harnessing the benefits of Financial Innovation rather than falling prey to its demons by Rajat Bhatia

In this series of blog posts, we are delighted to have imminent industry veteran Rajat Bhatia explain the concept of structured products and financial innovation.

Derivatives, Structured Products and Financial Engineering are terms synonymous with Financial Innovation and familiar to anyone who has been following the developments in global finance over the years. These products have been at the center of many a financial disaster in recent years prompting veteran Wall Street risk manager Richard Bookstaber to write an interesting book in the year 2007, titled “A Demon of Our Own Design – Markets, Hedge funds, and the Perils of Financial Innovation”. The disasters in the financial markets caused by the supposedly rare, once-in-a-million year “six sigma” events have been occurring at such regular intervals, that it is natural to question the prudence behind financial innovation.

Yet, these demons of our own design have grown enormously. Data from the Bank for International Settlements shows that the total notional amount of OTC Derivatives Contracts outstanding has grown from US$ 72 trillion in June 1998 to US$ 553 trillion in June 2015. Similarly, the Gross Market Value of these derivative contracts outstanding has grown from US$ 2.6 trillion to US$ 15.5 trillion. So is there a method in this madness or is it that our financial system is hurtling towards Armageddon. There must be a reason why derivatives have seen secular growth from 1998 until June 2008, when the Great Depression was at its peak. After June 2008, there was a period when the derivatives contracts outstanding declined, but by the middle of 2011, the market had grown again.

To answer this question and to find out how we can harness the benefits of financial innovation rather than fall prey to its demons, it will be helpful for us to see things in a historical perspective.

THE GROWTH OF FINANCIAL INNOVATION – A HISTORICAL PERSPECTIVE

Despite their recent induction into the halls of infamy, derivatives contracts have existed in the commodity markets for a long time. The Dojima Exchange in Osaka, Japan traded futures contracts on rice as far back as 1730. Japanese merchants had petitioned shogun Tokugawa Yoshimune to officially authorize trade in rice futures at the Dojima Exchange, the world’s first organized (but unsanctioned) futures market. For many years, the Japanese government had prohibited the trade of futures bills because it was widely regarded as a form of gambling that caused rice prices to rise. However, when the price of rice fell to record lows in the late 1720s, the samurai (whose income was tied to the value of rice) saw their economic position fall relative to the merchant class, whose growing economic power worried the nation’s elites. The shogun responded by easing restrictions on futures trading, but without officially sanctioning a futures market at Dojima.

Not just Japan, but the western world also saw the growth and development of the futures markets in the 19th century. The Chicago Board of Trade (CBOT) created the world’s first authorized futures exchange, based in Chicago in 1848. Three years later CBOT offered the earliest “forward” contract ever recorded. In 1865 , CBOT formalized grain trading with the development of standardized agreements called “futures” contracts and created the world’s first futures clearing operation when it begins requiring performance bonds, called “margin,” to be posted by buyers and sellers in its grain market. It was in 1870that the first octagonal futures trading pit was set up by CBOT.

The Chicago Butter and Egg Board established in 1898 became the Chicago Mercantile Exchange in 1919 and the first clearing house – the CME Clearing House was set up at the same time.1926– CBOT founds Board of Trade Clearing Corporation to guarantee its trades. Since then, there has been virtually no looking back for the Chicago derivatives houses. To support the agricultural commodity producers in the mid-west, CBOT launched the first futures contract on soybean in 1936followed by the first futures contract on frozen, stored meats such as pork bellies in 1961. Metals trading on CBOT began in 1969 when CBOT began trading its first non-agricultural product, silver futures.

It was, however, in the 1970s, that financial futures were launched with futures and contracts on seven foreign currencies making their debut on CME in 1972. CBOT launched the first interest rate futures, on the Government National Mortgage Association in 1975.

The first cash-settled futures contract, the Eurodollar futures was launched on CME in 1981. The first stock index futures contract on the S&P 500 Index was launched in 1982by CME and the first options on futures contract for U.S. Treasury Bond futures was launched by CBOT in the same year.

Electronic futures trading on the CME Globex platform started in 1992 and in 1997CME launched the first mini-sized, all electronic futures contracts on S&P 500 futures. Following on this success, CME launched the first futures contract on weather in 1999.

The fact that derivatives contracts have grown not just in volume but also broadened significantly from agricultural products in the 19th century to include contracts on metals, currencies, equity indices, fixed income and even weather in the 20th century, shows the popularity and advantages of derivatives.

However, there is a flip side to derivatives, structured products and financial innovation. That is to be found in the many derivatives linked disasters, which have started to occur with remarkable alacrity despite the enormous investments made in Risk Management and Information Technology by the major financial institutions. Recently the new CEO of Deutsche Bank has started a process of upgrading the bank’s Information Technology and Risk infrastructure as rumors about the bank’s enormous derivatives book have caused a steep fall in the bank’s stock price.

The last thirty years of global banking and finance has see a dramatic acceleration in financial innovation accompanied by an equally dramatic and often scary rise in the number of derivatives linked financial disasters, of which the sub prime and CDO crisis of 2007-2008 caused two major American banks Bear Stearns and Lehman Brothers to vanish from the face of this earth and bail outs of several other banks, both American and European.

In the next post by Rajat Bhatia, we will talk about Financial Chernobyls. Stay tuned! This, of course, is just a teaser to what you can expect at our 2-day Management Development Program on Structured Products and Financial Engineering by Rajat Bhatia on 28th and 29th March, 2016. Enrol Now!